Almost universally, franchise agreements expressly state that the filing of a claim in bankruptcy is grounds for immediate termination of the franchise agreement. But, in reality, bankruptcy laws, prohibit the franchisor from terminating the franchise agreement based on the franchisee’s filing in bankruptcy. This is referred to as a stay in bankruptcy.
A debtor [franchisee] in bankruptcy is shielded by the automatic stay under Sec. 362 of the Bankruptcy Code [11 U.S.C. 362] from debt-related proceedings brought by creditors [franchisor] based on pre-petition events.
A bankruptcy stay means the franchisor is not permitted to terminate or default a franchisee because of the filing of bankruptcy, delinquent royalties, or any other deficiencies that are pre-date the bankruptcy filing.
So what recourse does a franchisor have against a franchisee in bankruptcy? Two options include moving to dismiss the bankruptcy and seeking to lift the automatic bankruptcy stay, may be available. Either way, the franchisor must file a petition with the bankruptcy court. This is not a matter that can be handled by simply sending a notice to the franchisee or the franchisee’s attorney.
These two options were pursued by GNC in the case of In re: Meena, Inc[i]. While GNC was not successful in getting the franchisees’ bankruptcy dismissed or the automatic stay lifted,[ii] the court provided a nice outline of what is required for dismissal of bankruptcy claim and was is required to the lift the automatic bankruptcy stay.
The bankruptcy may be dismissed if:
- the continuing loss to or diminution of the estate [franchised business] and absence of a reasonable likelihood of rehabilitation;
- inability to effectuate a plan;
- unreasonable delay by the debtor [franchisee] that is prejudicial to creditors [franchisor]; [or]
- failure to propose a plan under section 1121 of this title [the federal bankruptcy law] within any time period fixed by the court.4[iii]
To the lift the automatic bankruptcy stay, the franchisor must show:
- the debor [franchisee] lack of adequate protection of an interest in property [franchise agreement or franchised business assets] of such party in interest; or
- the debtor [franchisee] does not have an equity in such property [franchise agreement or franchised business assets], and such property is not necessary for an effective reorganization.
[i] In re: Meena, Inc., Debtor. In re: Desa of NY, Inc., Debtor. In re: SDA, Inc., Debtor. In re: Choudry Sajid Javaid and Gulmeena Javaid, Debtors. ¶16,304. U.S. Bankruptcy Court, E.D. New York. Case Nos. 8-18-74693-reg, 8-18-74694-reg, 8-18-74695-reg, 8-18-74804-reg. Dated November 6, 2018.
[ii] GNC was not successful in getting the franchisees’ bankruptcy dismissed or the automatic stay lifted in part due to issues non-conveyance of the franchise agreement and money security agreement from the individual franchisees to the business entity franchisee. See are previous blog https://gettinslaw.com/franchising/2018/12/20/who-owns-this-franchise/
[iii] In re C-TC 9 th Avenue Partnership , 113 F.3d. 1304, at 1311 (2d Cir. 1997).